Canada's personal tax regime subjects a dividend received from a Canadian-resident corporation to tax at one of two effective tax rates depending on the tax treatment of the income of the corporation that paid the dividend. For a shareholder to claim the lower effective tax rate on dividends, the corporation paying the dividend must generally calculate and confirm that it has sufficient income eligible to support the reduced rate and designate the dividend as such. In Budget 2012, the Government announced a plan to simplify the designation process and facilitate late-filed designations. These changes should promote a more efficient tax system and ease the tax compliance obligations borne by Canadian-resident corporations.
The existing regime
Income earned by a corporation is generally subject to two levels of taxation. A corporation generally pays income tax on its corporate earnings, as do shareholders upon receipt of dividends paid out of the corporation's after-tax profits. To avoid "double-taxing" a single stream of income at both the corporate and shareholder level, the Income Tax Act (Canada) (the "Tax Act") allows Canadian-resident shareholders to reduce the tax payable in respect of dividends received from Canadian-resident corporations by claiming a dividend tax credit ("DTC").1
The amount of the DTC will depend on whether the dividend has been designated by the distributing corporation as an "eligible dividend" for the purposes of the Tax Act (an "Eligible Dividend"). Shareholders receiving an Eligible Dividend may claim an enhanced DTC whereas shareholders that receive a dividend that has not been designated as an Eligible Dividend (an "Ineligible Dividend") may only claim a standard DTC. In general terms, a corporation may designate a dividend as an Eligible Dividend if the underlying income to be distributed by the corporation has been subject to the general corporate income tax rate (currently 15% federally). Conversely, income that has been subject to reduced rates of tax at the corporate level (for example, income earned by a Canadian-controlled private corporation in respect of which the small business deduction has been claimed), will generally give rise to an Ineligible Dividend.
Currently, a dividend will only qualify as an Eligible Dividend if the corporation declaring the dividend has notified each shareholder in writing at the time of payment that the dividend is to be designated as an Eligible Dividend. Corporations are currently not permitted to late-file an Eligible Dividend designation. Accordingly, shareholders of a corporation are not permitted to claim the enhanced DTC in respect of a dividend (and thus are subject to a higher effective tax rate) if the corporation has failed to designate the dividend as an Eligible Dividend at the time it was paid, notwithstanding that the corporation may have had sufficient accumulated income, which was taxed at the general corporate income tax rate, to support the designation of the dividend as an Eligible Dividend.
In addition, under the current DTC regime, the Tax Act does not provide for "partial" or "split-dividend" designations to permit a portion of a single dividend to be designated as an Eligible Dividend and the remainder to be designated as an Ineligible Dividend. Accordingly, if only a portion of a dividend was attributable to income that could give rise to an Eligible Dividend, a corporation could not designate that dividend as an Eligible Dividend without potentially becoming subject to a penalty tax or subjecting shareholders to the consequences of electing to accept a portion of the dividend being re-characterized as an Ineligible Dividend. As a result of such practical challenges, it became standard practice in recent years for corporations to declare multiple, smaller dividends sequentially, several of which were designated as Eligible Dividends. Such sequential dividends permitted shareholders to access the enhanced DTC, and reduced the consequences to shareholders of an Eligible Dividend being improperly declared, but increased the administrative and tax compliance burden on corporations and their shareholders.
The Government proposes to permit the Minister of National Revenue (the "Minister") to accept an Eligible Dividend designation filed up to three years after the day on which the dividend was paid if "it would be just and equitable" to permit such a late designation. Budget 2012 does not elaborate on what factors the Minister will consider in determining whether the acceptance of a late-filed designation would be "just and equitable". Budget 2012 does, however, indicate that the Minister should consider the circumstances of the affected shareholders in determining whether a late filed designation should be permitted.
The Government also proposes to permit corporations to designate a portion of a dividend as an Eligible Dividend, while characterizing the balance of such dividend as an Ineligible Dividend. Such split-designations should allow corporations to distribute income eligible for the enhanced DTC and income ineligible for the enhanced DTC while reducing the number of separate, sequential dividends that a corporation may feel compelled to declare and pay. As under the current regime, the split dividend designation, designating a portion of the dividend as an Eligible Dividend, must be made in writing at the time the dividend was paid (subject to the above-discussed proposals to permit late-filed designations in certain circumstances). This proposed change follows a recommendation put forward by the Red Tape Reduction Commission.
The relief proposed by the Government in Budget 2012 should ease the compliance burden associated with the Eligible Dividend regime and could give rise to material tax savings to shareholders where a corporation has mistakenly failed to designate a dividend as an Eligible Dividend at the time the dividend was paid. These welcome developments apply to dividends paid on or after March 29, 2012.
1 The provinces generally provide comparable dividend tax credits to be credited against provincial income taxes.
The foregoing provides only an overview. Readers are cautioned against making any decisions based on this material alone. Rather, a qualified lawyer should be consulted.
© Copyright 2012 McMillan LLP